Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Sunday, October 19, 2014

PCAOB Panel Discusses Valuations of Financial Assets

The PCAOB Standing Advisory Group (SAG) discussed one of the most controversial and complex issues of financial accounting and auditing, estimates and measurements of financial assets, at a special meeting today. This discussion came against the backdrop of a consultation on the issues previously set out by the PCAOB.

International Accounting Standards Board Member Patrick Finnegan detailed five concrete recommendations to the PCAOB on the consultation. First, he endorsed a single standard aligning risk assessment standards with substantive testing. Second, he called for the use of third-party estimates of fair value. Complexity abounds in this area, he noted, and the use of third parties, such as for collecting data and applying it to models, could be useful and even necessary.

The IASB member’s third point involved the expectation gap. He believes that a single set of principles in this area would send a strong signal to the marketplace.

His fourth recommendation is that auditors should have access to the committee process of any entity assigning values to financial instruments. Auditors need a seat at the table to observe management’s discussion of valuations. His fifth and final recommendation is to place a heavy emphasis on auditor education in this area. There is a close nexus between experience and evaluating complex estimates and measurements. For example, auditors must have significant education to properly evaluate any impairment of assets. They must, for example, understand how credit risk changes in relation to events.

FASB Member Larry Smith said there is no silver bullet for auditing estimates and measurements of financial assets. Auditors have been auditing estimates forever, he noted, but fair value estimates have raised the level of concern over estimates and measurements.

SAG members had concerns about a single standard for all measurements, including fair value estimates. Philip Johnson cautioned the PCAOB not to be too prescriptive in the standard.

Former FASB Chair, and SAG member, Robert Herz said that this is a very important subject in moving financial accounting and auditing forward. The fair value standard reflects the view that sometimes management has to come up with best estimates, but, at the same time, actual market values should not be ignored. One of the problems that came out of the financial crisis was that some derivatives have no active trading. The reforms put derivatives on exchanges, he noted, and that will help to get a fair value estimate, but will not solve the problem completely. Quoted market price is a good metric, he added.

Mr. Herz chairs the Morgan Stanley audit committee. In that role, he likes to hear about any changes from quarter-to quarter in this area from the auditors or from management. Consistency is important in the area of valuation of financial assets and, similarly important is the need to detect any management bias. Risk management also plays a role in this area, said the former FASB Chair, as does understanding the challenges as they develop. Also, more broadly, this is part of good corporate governance. Standard setting should consider behavioral aspects, how people would react to situations.

The use of specialists in developing a valuation was debated. SAG member Jean Joy said that third-party specialists can be most useful in valuing assets and liabilities in acquisitions and business combinations, as well as in valuing Level 3 illiquid assets. But she cautioned that a troubling aspect of Level 3 is that here, even specialists have a wide variety of estimates.

Robert Herz, while noting that more and more firms have internal specialists, agreed with Ms. Joy that outside specialists are needed for valuing assets in business combinations.

SAG member Douglas Maine opined that it would be useful for the Board to issue guidance for the use of specialists in valuing financial assets and also ensure that audit committees are the first line of defense in this area. PCAOB Chief Auditor Marty Baumann revealed that the Board has asked the staff to prepare a consultation paper on the use of valuation specialists and that this project is on the staff’s agenda.

In conclusion, Barbara Vanich, PCAOB Associate Chief Auditor, said that there appears to be support for a single standard that emphasizes auditor skepticism and risk assessment. She said that the staff is interested in hearing the views of people on how the standard could be more principles-based.